Is It Time to Buy a Franchise?

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Talking to these franchisees is an essential part of due diligence, says Tom Pitegoff, a franchise attorney in White Plains, N.Y. "If you talk to nobody else, talk to the ones who left the system and find out why. Does it have something to do with the franchisor and something you should be looking out for?" While ex-franchisees may have sound reasons for leaving the system—retirement, for example— you should find out if they have complaints about the franchisor.

Look at the Bottom Line

You should also make sure that the company you're buying into is financially strong and able to sustain its growth. The franchisor's financial statements must be in the offering documents, and Pitegoff says you should get an accountant to review them. Even if you run your franchise well, it will be difficult to prosper if the franchisor is struggling, because brand reputations can suffer and unprofitable corporations may squeeze their franchisees for money. Also evaluate how strong the business model is. Just because a concept is being franchised does not mean it is proven, as eBay resellers discovered (BusinessWeek.com, 8/31/07).

Choosing an established franchise like McDonald's (MCD) can reduce your risk, though it will cost more than an unproven one. But don't mistake a brand name for a sound investment. Prominent brands falter, sometimes because they expand too quickly. Many franchisees for Boston Market, Krispy Kreme (KKD), and Quiznos bought in as the companies rode waves of popularity. Krispy Kreme weathered an accounting scandal and years of losses, Boston Market went bankrupt and is now owned by a private equity group, and Quiznos (BusinessWeek.com, 1/29/07) and other systems faced lawsuits from franchisees.

You should hire a lawyer who specializes in franchising to help you steer clear of a bad investment or a harmful contract, according to Les Stewart, a franchise consultant and industry watchdog who once lost his personal savings on a failed lawn-care franchise. Aspiring franchisees should expect to take six months to vet the opportunity and to spend 5% to 10% of their investment on legal fees, Stewart says. "If you're not, then you're unnecessarily gambling," he says. Lawyers should review the franchise offering, contract, and loan documents. For married franchisees, Stewart says both spouses need independent counsel, because both can be on the hook for debt if a venture fails.

Get It in Writing

Above all beware of hard-sell tactics and promises that franchisors refuse to put in writing. "If any promise is made, you should have it in writing, and if you put it in writing and it isn't included in a franchise agreement, you should assume you are dealing with a liar and a scoundrel," says Stewart. He says it's difficult to estimate how many franchises are bad bets because there is no comprehensive tracking of franchise failures. But he suggests that a majority of the new offerings being marketed are "non-sustainable," and that the number is greater than in the past. "These fly-by-night systems come in to the market because people allow them. They buy them and they think it's just like McDonald's."

For more advice on franchising, including an explanation of franchising fees, an interactive case study on a new franchisor, a round-up of suggestions from industry veterans, and more, read the rest of this special report.

Tozzi covers small business for BusinessWeek Online.